Abstract

The price of financial derivative with unilateral counterparty credit risk can be expressed as the price of an otherwise risk-free derivative minus a credit value adjustment(CVA) component that can be seen as shorting a call option, which is exercised upon default of counterparty, on MtM of the derivative. Therefore, modeling volatility of MtM and default time of counterparty is key to quantification of counterparty risk. This paper models default times of counterparty and reference with a particular contagion model with stochastic intensities that is proposed by Bao et al. 2010. Stochastic interest rate is incorporated as well to account for positive correlation between spread and interest. Survival measure approach is adopted to calculate MtM of risk-free CDS and conditional survival probability of counterparty in defaultable environment. Semi-analytical solution for CVA is attained. Affine specification of intensities and interest rate concludes analytical expression for pre-default value of MtM. Numerical experiments at the last of this paper analyze the impact of contagion, volatility and correlation on CVA.

Item Type:

MPRA Paper

Original Title:

Unilateral CVA for CDS in Contagion model: With volatilities and correlation of spread and interest